The PE Deal Series · Post D.8
View the full series →The Earnout Mirage
On paper it looks like real consideration. In practice, it's a performance bonus where the buyer sets the targets, keeps the books, and controls the business.
The earnout was $12M. When the earnout period was over, the founders received $2.8M. That's a 23% recovery rate on money the LOI said they'd earn.
Nobody lied. Nobody breached the contract. The structure worked exactly as designed — for the buyer.
Earnouts are the most common way buyers promise money after closing. They're also the form most likely to pay out at a fraction of the stated amount. The reason isn't bad faith. It's architecture.
The Bonus Your Boss Controls
You take a job with a $50K performance bonus. In a well-run company, the targets are written down, the measurement is objective, and both sides understand the terms before you start. Now imagine the opposite.
Your boss defines the targets after you've already accepted the job. The measurement criteria are vague enough that the final number is at your boss's discretion. And if you disagree with the calculation, your only recourse is to file a formal dispute — with your boss.
You'd never accept that deal in employment. In PE transactions, founders accept it routinely. The earnout is the bonus. The buyer is the boss. The measurement methodology is whatever the buyer's accountants say it is.
How the Mirage Works
The Crossfield earnout was structured as three annual payments tied to EBITDA targets:
- $4M — Year 1, if EBITDA hit $16.2M
- $4M — Year 2, at $17.5M
- $4M — Year 3, at $18.9M
Aggressive but achievable — based on Crossfield's trailing performance.
Three problems made those targets a mirage.
No committed funding source. The purchase agreement didn't require Ridgeline to set aside money for the earnout. No escrow. No reserve. The earnout was a promise backed by Ridgeline's general obligation.
Buyer-controlled EBITDA calculation. Ridgeline's accountants determined the figure each year. Management fees and integration costs were deducted — costs that didn't exist when the founders ran the business.
Revenue redirection. In Year 2, Ridgeline moved two of Crossfield's largest accounts to a bolt-on acquisition. The accounts still generated revenue — just not for Crossfield's standalone EBITDA. Year 2 missed by $1.3M. Year 3 missed by $2.1M.
James disputed the Year 1 calculation and recovered $2.8M of the $4M tranche. He never contested Years 2 and 3. The revenue redirection that killed those targets was permitted under the purchase agreement. The result was less money for James. Coincidence? Probably not.
$12M on paper. $2.8M in cash. The earnout didn't fail because Ridgeline cheated. It failed because the buyer controlled how EBITDA was measured.
Deal Spectrum: 10/10
The left column shows what a founder-favorable version of this term looks like. The right column shows what Crossfield signed.
The mental model is the Earnout Mirage. The earnout looks like money on the table. The buyer controls the targets, the measurement, and the business decisions that determine the outcome. The number on the page and the number on the wire are two different things.
The Crossfield Moment
At the Year 2 review, James sat across from Ridgeline's CFO. The EBITDA calculation showed $16.2M — $1.3M below the target. James pointed to the two accounts redirected to the bolt-on acquisition.
The CFO nodded. "Those accounts are serviced by the new entity now. That's an operational decision, not an earnout adjustment."
James had the purchase agreement in front of him. The EBITDA definition allowed it. The contract protected the buyer.
The earnout was never designed to pay in full. It was designed to be technically defensible at whatever number the buyer chose.
Founder Protection Tips
Negotiate dedicated funding — place at least 50–75% of the earnout amount in escrow at closing. If the money isn't set aside, it doesn't exist.
Negotiate tight, objective definitions with seller participation in the EBITDA calculation. Clear add-backs and explicit prohibitions on revenue or cost shifting to affiliates.
Include anti-sandbagging covenants. Prevent the buyer from taking operational actions — account transfers, overhead allocations, management fees — intended to suppress earnout performance.
Push for independent arbitration with a neutral accountant, paid primarily by the buyer. If you have to fund the dispute, you won't file it.
Cap the earnout period at one to two years maximum. Longer periods almost always favor the buyer — more time to redirect, reallocate, and restructure.
Read before you sign.